Bankruptcy Court Decides the Bankruptcy Code Preempts California State Pension Laws

Nossaman eAlert

In a February 4, 2015 opinion, the bankruptcy judge presiding over Stockton, California's Chapter 9 municipal bankruptcy case approved Stockton's bankruptcy plan of adjustment. 

In re City of Stockton, 2015 Bankr. LEXIS 360 (Bankr. E.D. Cal. Feb. 4, 2015).  The bankruptcy court overruled the objection to the plan made by one of Stockton's creditors, Franklin Templeton Investments ("Franklin").  Franklin objected to Stockton's bankruptcy plan because the plan didn't provide for modification of the city's contractual obligations to the California Public Employees' Retirement System ("CalPERS") or Stockton's other pension related debts.  Franklin asserted that Stockton's bankruptcy plan could not be approved because it would substantially adjust the city's debts to capital markets creditors, including Franklin, while at the same time leaving pension plan obligations unimpaired.  Franklin argued that, as a result, Stockton's plan of adjustments did not satisfy the Bankruptcy Code requirement that the plan be "fair and equitable" and that Stockton's bankruptcy plan unfairly discriminated in favor or retirees and pension plan participants. 

As discussed below, the bankruptcy court disagreed with CalPERS' assertion that applicable law prohibited Stockton from rejecting its CalPERS contract or from adjusting its debts to CalPERS and pension plan participants.  At the end of the day, however, the bankruptcy court approved Stockton's plan despite the fact that Stockton made the decision not to take advantage of its legal power to impair CalPERS' and plan participants' interests.  Barring reconsideration or reversal on appeal, Stockton could exit Chapter 9 bankruptcy proceedings leaving all of its obligations to CalPERS and pension plan participants intact.  Other municipalities, however, may attempt to take a different approach in their bankruptcy plans and look to the Stockton opinion for authority to adjust their pension related debts.

It should be noted that the Stockton bankruptcy case and other Chapter 9 cases involving pension plans administered by CalPERS differ from those bankruptcies in which the municipalities' pension plans are self-administered or are administered by entities other than CalPERS.  The unique California statutes governing CalPERS and its contracting employers, which statutes are addressed at length in the Stockton opinion, would not be directly applicable to bankruptcy cases involving other kinds of retirement plans and those differences could lead bankruptcy courts to reach different conclusions in those cases. 

In considering Franklin's objection, the court initially addressed whether Stockton had the legal power to modify its obligations to CalPERS as pension plan administrator, or the city's debts to the retirement plan participants themselves.  If the City was not entitled to modify or reduce those obligations, the city's decision not to attempt to do so could not be questioned.  Franklin's plan objection therefore would be overruled.  However, even if the bankruptcy court found that Stockton was legally permitted to modify those obligations if the city had elected to do so, the court still would need to, and in fact did, address whether Stockton's proposed plan complied with the Bankruptcy Code despite the fact that Stockton did not avail itself of that legal right. 

The bankruptcy court rejected CalPERS' arguments against Stockton's power to modify its obligations to CalPERS or to pension plan participants in bankruptcy.  First, the court found that the California statute prohibiting a municipality from rejecting its CalPERS contract (Cal. Gov't Code § 20487) was preempted by 11 U.S.C. § 365, the Bankruptcy Code provision granting debtors, including municipalities under Chapter 9, the ability to assume or reject executory contracts. 

Second, the court ruled that the lien securing CalPERS' collection of termination charges owed by a participating entity upon termination of its CalPERS agreement (which obligation the bankruptcy court characterized as "confiscatory" because of how the charges are calculated under the CalPERS statute) could be avoided in bankruptcy.  The bankruptcy court found that because the lien normally would not arise until a post-bankruptcy termination of the contract, the lien could be avoided pursuant to 11 U.S.C. § 545.  The bankruptcy court found that the California statutes relating to rejection of CalPERS' contracts in bankruptcy and creating a statutory lien in favor of CalPERS are trumped by Congress' exclusive power to enact uniform bankruptcy laws and the Supremacy Clause of the United States Constitution.  (U.S. Const. art. I, § 8 and art. VI.) 

Finally, the bankruptcy court also determined that Stockton could properly modify its debts to the retirement plan participants themselves (employees, retirees and their beneficiaries) as well as to CalPERS.  Stockton was entitled to exercise the right to reject such agreements pursuant to section 365 of the Bankruptcy Code notwithstanding the Contracts Clauses of the California and United States Constitutions as applied by the "Vested Rights Doctrine" developed and affirmed in numerous California judicial decisions.  The court addressed the separate question of Stockton's right to reject contracts with plan participants because, in the bankruptcy court's view, the plan participants rather than CalPERS were the "real creditors" with respect to benefit payment obligations as opposed to the termination charges payable to CalPERS when the CalPERS contract is terminated.  (The court did state, however, that rejecting the contracts with the pension plan participants, as opposed to the CalPERS contract, could be subject to the more stringent standards applied to debtors seeking to reject collective bargaining agreements.)  The court also decided that preempting the relevant CalPERS statutes did not constitute the kind of "interference" with the State's control over a municipality's "political or governmental" powers of the kind that is barred by sections 903 and 904 of the Bankruptcy Code or the Tenth Amendment to the United States Constitution.

Once the bankruptcy court reached the conclusion that Stockton could have modified CalPERS' and plan participants rights, the court addressed whether the city's failure to do so prevented approval of Stockton's bankruptcy plan of adjustment.  The court concluded that employees and retirees in fact were "sharing the pain" with capital markets creditors like Franklin.  The bankruptcy court noted that Stockton did terminate its program for lifetime retiree health benefits and that the city's bankruptcy plan also indirectly reduced Stockton's pension liabilities by lowering salaries and curtailing future pay increases pursuant to renegotiated collective bargaining agreements with its active employees.  Accordingly, the bankruptcy court concluded that the city's choice to achieve savings by negotiating salary and benefit adjustments rather than by pension modifications was appropriate, and confirmed the city's proposed plan as feasible and in the best interests of the creditors.  

It is unclear what the future holds for the bankruptcy court's opinion.  Whether CalPERS is an "aggrieved" party for appeal or judicial review purposes because the plan as approved actually leaves CalPERS' interests unimpaired goes beyond the scope of this E-Alert.  Of course, a threshold issue is whether or not Franklin or any other party will seek review of the bankruptcy court's opinion under the circumstances.

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